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Wednesday, February 26, 2003

Deflation in China Continues

Arguing that, in the case of deflation in China, its not over till its over, Andy Xie explains that massive surplus labour and capital supplies in China mean that deflation can be expected to continue, with the global PPI being driven from China. I agree with him.

China’s CPI possibly rose in January from a year ago. This would be the first positive year-on-year change since the fall of 2001. Some may interpret this as a sign that deflation is ending in China. This would be a mistake, in our view. China’s CPI is a lagging indicator to export performance. The CPI stayed positive for six quarters in the last export recovery. A rise in the CPI reflects higher commodity prices during a trade upturn. China’s CPI functions as the producer price index for the global economy.China’s economic development is a deflationary process. This is the nature of industrialization of a large economy with surplus labor and capital. The United States also experienced deflationary industrialization, as immigration created a horizontal labor supply curve, and high domestic savings and capital inflow led to ample supply of capital. Rapid productivity growth in a large economy with no constraints on labor and capital supply is passed on to consumers in lower prices.

Raw material cost is the most important and, probably, the only meaningful, parameter for China’s inflation since the mid-1990s. Labor and capital supplies have exceeded demand and their prices do not respond to demand. Raw material cost has become the only independent variable in inflation. It is a race between productivity and raw material cost. When demand rises fast enough, material cost will rise faster than productivity and, thus, trigger an increase in the finished product price. The purchasing price index for raw materials was up 1.3% in December 2002 from a year ago compared with a 4.8% decline in January 2002. The rise in raw material prices in China in December was much less than in the international market. The CRB index was up 26.4% in December 2002 from a year ago. The raw material component of the US Purchasing Price Index was also up 26% during the same period.China’s raw material price has fluctuated by one third as much as the international market price. This may partly be due to the index composition. However, China’s data may have understated the fluctuation. Recent anecdotal evidence points to a quite dramatic rise in raw material prices. Chinese statistics have a tendency to smooth trends. China’s raw material prices tend to lag international prices. This may be a statistics collection issue rather than any substantial disconnect between China’s and the international market.If the past pattern prevails, China’s raw material price index is likely to accelerate to an 8% increase six months from now. This is similar to the peak in 2000. It should be interpreted as statistics catching up with reality. The CPI should be able to stay in positive territory for four quarters.
Source: Morgan Stanley Global Economic Forum

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